Trade 40-7

Deriving the Autarky Terms of Trade

The Ricardian model assumes that all workers are identical or homogeneous
in their productive capacities and that labor is freely mobile across industries.
In autarky, assuming at least one consumer demands some of each good, the
country will produce on the interior of its PPF. That is, it will produce
some wine and some cheese.

Profit maximizing firms would never set a wage rate above the level set in the other industry.
Why?

Suppose the cheese industry set a higher wage such that wC >
wW. In this case all of the wine
workers would want to move to the cheese industry for any wage greater than wWSince their
productivity in cheese is the same as the current cheese workers and since it does not cost
anything for them to move to the other industry, the cheese industry could lower their costs and
raise profit by paying a lower wage. To maximize profit they must lower their wage. Thus only
equal wage rates can be sustained between two perfectly competitive producing industries in the
Ricardian model.

In autarky, then, wC = wW

Plugging in the relationships derived above yields,

or

This means that the autarky price ratio (cheese over wine) or terms of trade equals the
opportunity cost of producing cheese. Another way to say the same thing, is that the price of
cheese (in terms of wine) in autarky equals the opportunity cost of producing cheese (in terms of
wine).